Debunking the “Conservative” Argument for a Wealth Tax

Daniel J. Mitchell
Posted: Jan 17, 2012 12:01 AM

Last year, I debunked the silly claim that Obama is a conservative.

I almost didn’t write that post. Some things, after all, presumably don’t require a response. Would I waste my time, for instance, responding to someone who claimed that Milton Friedman was a communist?

But sometimes it’s necessary to counter absurd arguments, precisely so they don’t gain a foothold among otherwise sensible people.

That’s why it’s time to write about the economics of a wealth tax.

And I’m doing this because Ronald McKinnon, an economics professor at Stanford University, recently wrote a column for the Wall Street Journal entitled “The Conservative Case for a Wealth Tax.”

I could make this post very short and simply note that there is no conservative (or libertarian) case for higher taxes, period. But let’s use this opportunity to explain the economic impact of taxing wealth.

Professor McKinnon starts out with a very sensible point about the foolishness of higher income tax rates.

…any attempt to impose higher marginal tax rates on even moderately high income earners—as President Obama wants for families earning more than $200,000 per year—can lead to losses in economic efficiency and even to losses in sorely needed government revenue if high earners work less or seek out more loopholes and tax shelters.

I particularly like his point about potential revenue losses. For all intents and purposes, he is saying the Laffer Curve is very strong for those with high income – a point I have made in previous blog posts.

Unfortunately, he then forgets this good analysis and urges a tax on wealth.

In order to have a fairer tax system, we should implement a new federal wealth tax in addition to the federal income tax. Unlike the current income tax, the wealth tax would not rely on how income is defined. Rather, it would require that households list all their domestic and foreign assets on, say, Dec. 31 in the relevant tax year. …If on Dec. 31 a household declares total net assets of $5 million, and the “standard” wealth tax exemption is $3 million, then its wealth tax is $60,000 ($2 million x 0.03). Because wealth will generally present a much larger tax base than income, tax rates can be kept low and still raise substantial revenue. The incentive for tax avoidance is minimal—unlike the incentive created by a high marginal income-tax rate of 40% or more for earners paying both federal and state income taxes.

There are two big problems with McKinnon’s analysis. First, he wants us to believe a 3 percent tax on wealth won’t hurt the economy, but he apparently doesn’t understand that a wealth tax is actually a tax on the returns to capital.

Do we want rich people to create future growth with investment, or do we want to encourage them to engage in lavish consumption instead?

Let’s use a simple example. Imagine that I’m a rich person with $100 million that I’ve accumulated over the years. And let’s further assume that I’m a savvy investor. Even though the economy is weak, I manage to get a 5 percent return on my capital, so my $100 million is now worth $105 million.

But Uncle Sam wants to grab $3 million because of a new wealth tax. That is akin to a 60 percent tax rate on my new wealth!

And don’t forget that the IRS will probably be grabbing some portion of that additional wealth because of income taxes, capital gains taxes, and double taxation of dividends.

Here’s the bottom line: The wealth tax is really a tax on saving and investment. And the tax rates are likely to be very high.

Indeed, if the economy is sour and portfolios are growing at less than 3 percent, the tax rate can be more than 100 percent!

You don’t have to be a wild-eyed supply sider to conclude that there may be some negative effect on incentives to save and invest.

Heck, even if there is a bull market and portfolios are expanding at 15 percent, the tax rate is still 20 percent. And keep in mind all the other layers of tax that would still exist, so the effective marginal tax rate will still be punitive.

The second problem with McKinnon’s analysis is that he acknowledges big evasion and avoidance problems caused by 40 percent income tax rates, but he somehow assumes those problems will disappear if we impose a wealth tax.

Indeed, he even references the infamous FATCA legislation. But that legislation is a disaster, imposing crippling burdens on overseas Americans and driving investment out of the American economy. If that’s an indication of how a new wealth tax would be enforced, then we can all look forward to a turbo-charged IRS with even more powers to wreck our lives and disrupt our economy.

In reality, evasion, avoidance, and punitive economic costs are inevitable when taxes become too onerous. Professor McKinnon wants us to think that the costs can be reduced with a wealth tax. He’s right that some forms of taxation do less damage than others, but his proposal would make things worse, not better.

The only potentially good thing about his plan (and I admit that I’m motivated by pettiness) is that it would tax hypocritical leftists such as Warren Buffett, who argue for higher income tax rates, secure in the knowledge that they will be largely unaffected.

But I’m not willing to hurt the economy just to go after a handful of rich and dishonest statists. My goal is to create a more prosperous economy to help the less fortunate.